Financial Analysis for Your Business
Financial Statements are designed to report on the performance and financial position of the entity. The objective is to communicate the results of its operations in a way that will be meaningful and helpful to the users. Reading accounts in the format in which they are normally presented will add only limited value to the readers understanding of what the figures tell about the performance of the business. To add more value to the data obtained from accounting information it is necessary to undertake more detailed analysis of the figures and in particular to examine the interrelationships between different figures in the Financial Statements and to compare them with different periods and with different businesses. Accounting Ratios are used for these purposes.
1.1 Accounting Ratios
Accounting Ratios are the tools of Financial Analysis which describe the relationships existing between different items in financial statements. Because a ratio simply describes the relationship between two figures there is an almost endless number of ratios which could be established between all the figures in financial statements. It is necessary, therefore, to narrow down the number to those relationships which will give useful information about the business. There are essentially three types of ratios which can help to give a clearer picture of the performance and financial viability of the business. These are a selection of specific ratios which deal with the
of a business.
It is important to note the wording “can help to give a clearer picture”. This does not in any way imply that they give the full picture. The best that ratios can do is to indicate the areas and items which should be subjected to more detailed examination and questioning. There is a tendency, for accountants particularly, to place over reliance on ratios for understanding what is going on in a business. Ratios can tell what has happened but they do not tell why something has happened. It is very important to understand the strategy to which a business is working in order to fully understand and properly assess the performance of the business. The ratios alone cannot give this full understanding. At best they highlight areas that should be looked at in more detail and provide information that will facilitate a better informed discussion with the management of the business. It is important also to bear in mind that Accounting Ratios are based on accounting figures which are at best subjective in many respects.
Subject to these important caveats Ratios can be particularly useful in highlighting trends within a business when viewed over periods of time either historic or projected. It is therefore usually more beneficial to look at corresponding ratios over periods of time rather than in isolation and to look at groups of ratios rather than individual ones. A major benefit of ratios is that they facilitate valid comparison between different periods by eliminating the impact of volume changes. It is particularly important to fully understand both the implications and the limitations of ratios if they are to be effectively utilised. If they are fully understood then accounting ratios can be a very useful tool of financial analysis.
We will now look at those selected ratios which are particularly useful in analysing the financial performance and stability of a business.
1.1.1 Profitability Ratios
Profitability Ratios give an indication of the efficiency of operation of a business.
There are two types of Profitability Ratios:
- Those which show profitability in relation to sales.
- Those which show profitability in relation to investment in the business.
PROFITABILITY IN RELATION TO SALES
SALES COST OF SALES
2.1.1( a) GROSS PROFIT RATIO: ————————————
This ratio tells the profitability of the business relative to Sales after deducting the cost of producing the goods which have been sold. In a trading business the cost of sales is usually taken to be simply purchases of goods for resale adjusted for opening and closing stock and will reflect the level of “mark up” or margin being applied. In a service business cost of sales will be the labour and other direct costs involved in delivering the service to the client. In a manufacturing business the cost of sales will include all Material, Labour and Overhead costs incurred in producing the goods which have been sold.
The Gross Profit Ratio is the main driver of profitability in the business as all the other profitability ratios are derived from it. In itself it is an indicator of the production efficiency of the business before measuring the impact of selling and general management costs. It is also an indicator of the effectiveness of the product pricing policy of the business. In analysing the Gross Profit Ratio it should first be compared with the budgeted Gross Profit Ratio to ascertain how well the business has performed, at this level, against its own target. It should then be compared with the ratio for the previous period to establish whether the trend in the ratio is improving or disimproving . If, for example, the Gross Profit Ratio has fallen in relation to the previous period we know that either increased material or labour costs have not been recovered in higher selling prices and/or inefficiencies have arisen in the production process. This will have happened either because the increased costs or inefficiencies have not been identified or, if they have been identified, it has not been possible to cover the cost of them in increased selling prices. The final comparison of the Gross Profit Ratio should be to benchmark it against other businesses in the same sector to establish relative performance against peer businesses.
If more detailed analysis is required on a Gross Profit Ratio which has moved either up or down the individual cost items or groups of items comprising Cost of Sales should be expressed as a percentage of Sales in each period and it will then be possible to identify which particular area or areas has caused the movement in gross profitability. In a manufacturing business this will involve comparing the Material, Labour and Production Expense costs as a percentage of Sales in each period. While this will indicate the specific area of improvement or deterioration it will not explain why the particular movement has happened. The precise reason for the change can only be ascertained through discussion with the relevant line manager in the area involved.
2.1.1 (b) OPERATING PROFIT RATIO ————————
(Operating Profit = Sales — Cost of Sales — S G & A Expenses)
This ratio tells the profitability of the business relative to Sales after deducting all the costs of producing and selling the goods which have been sold. Operating Profit is sometimes called Profit Before Interest and Tax. (PBIT) or Earnings Before Interest and Tax (EBIT). It measures the impact of the selling and administration expenses on the Gross Profit.
The Operating Profit Ratio is one of the best measures of the efficiency of the operating management of the business and indicates management’s ability to generate profits from the operations of the business before deducting costs or adding in income that have nothing to do with operating efficiency.
The Interest Factor.
It is important to note that the cost of producing and selling goods does not include Interest. The reason for this is that interest primarily reflects the Capital Structure of the business and has little to do with the efficiency of operating management. It is also heavily influenced by prevailing interest rates over which operating management has no influence at all. To deduct the interest charges before calculating Operating Profit and assessing the Operating Profitability of the business would mask the efficiency or otherwise of the operating parts of the business. The operating management has no control over the Capital Structure of the business. It is determined by the owners through their level of equity contribution to the business.
There is however one aspect of the financing/capital structure which the operating management can control and that is the whole area of Working Capital and Fixed Asset management . For this reason sometimes that part of the overall interest charge which arises from fluctuations in Working Capital is included in SG&A Expenses and thus taken into account when assessing operating profitability. But even though management has some control over the amounts tied up in assets the basic structure of the financing of those assets will still be determined by the Capital Structure and in a situation where there is, of necessity a lot of debt in the capital structure, the capacity of management to influence the level of interest charges will be relatively small.
When examined in association with the Gross Profit Ratio the Operating profit Ratio gives a very good indication of where the improvements or disimprovements in profitability in the business have occurred. If more detailed analysis is needed the constituent items or groups of items comprising Selling, General and Administrative Expenses can be examined and expressed as a % age of Sales to determine more precisely where the changes have occurred. But the reasons for the change can only be ascertained from discussion with the appropriate line managers responsible for the particular expenses area.
By their nature S, G and A expenses include significant amounts of fixed expense, particularly in the G and A elements where there will be a lot of central overhead and general management expenses, eg Finance, HR, Chief Executives office etc.. Because of this it would be normal to expect S,G & A Expenses as a % of Sales to decrease as the volume of Sales increases. When analysed it will probably be found that the Selling expense moves in line with Sales but the General and Administrative elements should move in sympathy with rather than in direct line with Sales volumes.
This can be illustrated graphically as follows:
PROFIT BEFORE TAX
2.1.1 (c) PRE-TAX PROFIT RATIO ————————
(Profit before Tax = Operating Profit — Interest Charges)
This tells the profitability relative to Sales after deducting all the costs incurred in the business but before taxation. It reflects, in full, the impact of the capital and financing structure of the business on its profitability. It is a general indicator of the overall profitability of the business relative to Sales
The only difference between this ratio and the Operating Profit Ratio is the impact of Interest so that when the two ratios are looked at together the impact of the capital structure on the profitability of the business can be clearly seen. It could be found, for example, that a business which has a consistently good Operating Profit Ratio could have a consistently bad and even deteriorating Pre-Tax Profit Ratio over the same periods. This is caused by levels of interest charges, arising from inappropriate capital structure, which are excessively high in relation to the earning capacity or efficiency of the business. If the capital structure is wrong then even if the business is operating at maximum efficiency in terms of production, selling and administration it may never be able to make a Pre-Tax Profit because of the high financing charges.
PROFIT AFTER TAX
1.1.1 (d) NET PROFIT RATIO ———————-
This is the profitability of the business after deducting all costs including taxation. It is an indicator of the overall efficiency of the business in terms of its “bottom line” performance.
The only difference between it and Pre-Tax Profit Ratio is the Taxation charge and by comparing these two ratios over periods of time an indication of the efficiency of management in minimising the tax charge can be ascertained. The capacity of any management to do this is limited and care must be taken not to overexpose the business in terms of capital commitments or other arrangements designed to minimise tax but which my cost the business significantly more in the long term than the tax saved.
PROFITABILITY IN RELATION TO INVESTMENT
1.1.1 (e) RETURN ON CAPITAL EMPLOYED ——————-
This is also called the Return On Net Assets Ratio and is sometimes referred to as the Primary Ratio. Capital Employed is the total of Shareholders Funds and Term Liabilities or expressed in terms of assets as Total Assets (ie Fixed assets + Current Assets) minus Current Liabilities. The Operating Profit figure is used because loans are included in the Capital Employed and therefore the return on them must be calculated before charging the interest on them. The return has to provide for the interest. The Return On Capital Employed (ROCE) ratio is the most important measure of the overall efficiency of the management of the business because it relates the overall results of operations to the total amount of funds invested in the business.
In calculating it this way it avoids the distortions which might arise from different capital and financing structures and therefore gives a measure of the efficiency with which the resources of the business have been utilised irrespective of how they have been financed. This is the ratio which is most relevant for internal assessment of performance both against budget and as compared with similar businesses.
PROFIT AFTER TAX
1.1.1 (e) RETURN ON EQUITY ————————–
This relates the “bottom line” to the Shareholders’ investment in the business and shows the overall return on the Shareholders’ investment in the business after taking account of everything including the impact of leverage. This is the ratio that investors will be interested in as it indicates the overall return available to the Equity investors.
For businesses with the primary aim of Maximising Shareholder Wealth this has to be the principal ratio on which performance is judged and its optimisation has to be its primary objective. The Return on Equity reflects the impact of the Capital Structure on ROCE.
2.1.1 (f) NET ASSET TURNOVER —————————-
NET TOTAL ASSETS
This describes the number of times the Total Net Assets (Total Assets minus Current Liabilities) are “turned over” in terms of Sales. It measures the efficiency of the business in terms of its ability to utilise its assets to generate sales.
It is sometimes described as an Efficiency or Activity Ratio as it measures the volume of activity generated from using the net Assets. It is a measure of overall efficiency but its maximisation should not be an objective in itself because volume is of no value if it is not profitable. So it is best to consider this particular ratio in association with the other profitability ratios rather than in isolation.
In particular if it is linked with the Operating Profit Ratio it can effectively provide the key to the overall profitability of the business:
OPERATING PROFIT RATIO X NET ASSET TURNOVER = ROCE
This equation effectively defines the components of overall profitability and all of the other Profitability Ratios are derived from it. If overall profitability is taken to be adequately reflected in ROCE then there are only two ways in which it can be improved:
- By increasing the Operating Profitability and this has to be achieved through reducing costs and/or increasing prices i.e. the Cost/Price side of the equation.
- By increasing the Net Asset Turnover and this has to be achieved through increasing sales volumes and/or reducing assets i.e. the Volume/Investment side of the equation.
If these fundamental profitability ratios are understood then the whole process necessary for maximising profitability becomes clear.
1.1.2 Liquidity Ratios
Liquidity Ratios help to define the ability of the business to meet its day to day obligations and also help to more precisely define the liquidity of individual short term assets and liabilities. They also help to assess the appropriateness of the financing structure of the business in terms of the matching of maturities of assets and liabilities which is so essential to the financial viability of a business.
1.1.2 (i) CURRENT RATIO ————————–
This compares the Current Assets (Cash, in all its forms, Receivables and Stock) with the Current Liabilities (Payables, Short Term Debt, the Current portion of Long or Medium Term Debt, Accrued Taxes and other Accrued Expenses). The Current Ratio is the most commonly used ratio for assessing liquidity because it clearly indicates the extent to which the short term obligations of the business are covered by assets of similar maturity or in other words assets which are expected to be converted to cash in approximately the same timeframe as the short term obligations will fall due for payment. Viewed over periods of time the Current Ratio is a good measure of the adequacy of Working Capital.
Every business has an optimum level of working capital i.e. excess of Current Assets over Current Liabilities which it needs to support its day to day trading activity. The exact level of this will vary from industry to industry and from business to business within each industry. When the optimum level of Working Capital has been determined for a particular business the Current Ratio should then remain constant irrespective of volume changes. It is therefore a good measure of the adequacy of this working capital figure viewed over periods of time and is much more meaningful than comparing the actual figures of working capital which will be constantly changing in line with changes of volumes. If the Current Ratio is found to be reducing over periods of time it can indicate potential liquidity problems and trends leading to overtrading.
But in some senses the Current Ratio is a rather crude measure of liquidity particularly when looked at in isolation. This is because it does not take into account the liquidity of the individual components of Current Assets and Current Liabilities. Generally it is agreed that a Current Ratio of about 2:1 is the most appropriate level for most businesses i.e. short term maturing assets running at about twice the level of short term maturing obligations. But many businesses can survive and even trade quite successfully with ratios of considerably less than 2:1 and conversely others with ratios of 2:1 or higher may go out of business because of liquidity problems! An example will illustrate:
If a business has Current Assets of €1000 and Current Liabilities of €500 then its Current Ratio of 2:1 would appear to indicate a strong liquidity position. But if the Current Assets comprise €750 Stock and €250 Receivables who when requested to pay have difficulty doing so, while the Current Liabilities comprise €500 Payables overdue and demanding payment, the business is unable to meet its short term obligations and if petitioned by the Creditors could be put into liquidation because of this inability. In such a case the Current Ratio of 2:1 would prove to be a very poor measure of liquidity.
If the Current Ratio is in excess of say 2.5 or 3:1 then it usually indicates a degree of underutilisation of assets which could indicate some deficiencies in management of its assets.
CURRENT ASSETS — STOCK
1.1.2 (ii) QUICK ASSET RATIO
This is also called the Liquid Ratio or the Acid Test Ratio. It eliminates from Current Assets the least liquid assets in order to get a more incisive measure of liquidity. All the items in Current Liabilities remain so that it shows liquid assets against all the current liabilities (Current Liabilities include everything due within twelve months of the Balance Sheet date). It is a more incisive measure of liquidity than the current ratio
While the Quick Asset Ratio is a more severe test of liquidity than the Current Ratio it also suffers from the defect that it does not define the liquidity of the individual components of liquid assets and current liabilities. These individual liquidities could be crucial to the overall liquidity of the business. While a Quick Asset Ratio of 1:1 is generally considered appropriate i.e. liquid assets at least sufficient to cover all short term obligations many businesses can survive and trade with ratios considerably less than that and others have liquidity problems with ratios well in excess of it. An example will illustrate:
If a business has Liquid Assets of €500 and Current Liabilities of €1000 its Quick Asset Ratio of 0.5:1 would appear to indicate liquidity problems. But if the Liquid Assets comprise €400 cash and €100 receivables while the Current Liabilities comprise €400 Payables due in three months and Taxation due in nine months the business is able to cover its short term obligations and will probably be able to generate further cash to meet the other obligations before they become due. Thus, viewed in isolation, the Quick Asset Ratio would have given a misleading signal.
Like the Current Ratio the Quick Asset Ratio can be very useful when examined over periods of time in identifying adverse trends in the liquidity of the business. As with all ratios it is important to remember that these liquidity ratios are only indicators of position and trends and they do not give the full picture. The trends or position highlighted by these ratios should be further investigated through discussion with the line management directly involved in the particular areas highlighted. It is particularly important that, before drawing any definitive conclusions from an assessment of these liquidity ratios, a detailed examination of the quality and ageing/maturity of the individual components of Current Assets and Current Liabilities is undertaken. It is only after such examination that any meaningful interpretation can be made. The next three Liquidity ratios will help in this assessment.
RECEIVABLES X NO. OF DAYS IN PERIOD
1.1.2 (iii) COLLECTION PERIOD ————————————————–
This ratio which is also called Days Sales Outstanding (DSO) gives an estimate of the number of days credit being taken by customers of the business. It therefore gives some indication of the liquidity of the Receivables item in Current Assets. It is important to note that it only gives an estimate of the number of days credit being taken by customers. A more accurate measure would be based on an average of the monthly receivables figure and a figure for credit sales rather than total sales. However for general purposes and for comparison from period to period the figures as calculated above will be a very good indicator of the credit trends within the business and of the liquidity of Receivables.
Very often this ratio is defined as Receivables X 365 / Sales. It is important that this caluculation is only relevant if assessing the ratio for a one year period. If the ratio is being assessed on the Half Year Accounts then a figure of 182 days should be used and for quarterly accounts it would be 90 days.
In assessing the Collection Period it should firstly be compared with the actual credit terms being given to customers. This will give a measure of the efficiency of the credit control procedures in the business but it may also give a guide to the likely quality of the Receivables. If, for example, the credit being taken far exceeds the period being quoted to customers the hope would be that it reflects deficiencies in the Receivables management area. If, in such circumstances , Receivables management is found to be good then it indicates inability of customers to pay on time and that would be a much more serious problem.
The Collection Period should then be compared with the normal terms of trade within the particular type of business. Any significant divergence from the norm for the industry should be discussed with the relevant line managers to establish the reasons for the divergence. Knowing the normal terms of trade for the industry is also important for the Financial Manager in the context of not insisting on credit terms that would have the effect of losing business because they were outside the norm for the industry.
In this context it is also essential to compare the Collection Period with the normal terms of trade within the geographic area in which the business is operating. There are significant difference , for example, between what is normal in Northern Europe compared to what is considered normal in Southern Europe. These ‘cultural’ differnces should also be taken into account.
The Collection Period should then be compared with the corresponding figure for the previous period. The reasons for any changes from one period to the next should be ascertained from discussions with the line managers involved. This is particularly important not just in comparing with past performance but also in assessing the validity of projections for future periods.
The final comparison should be with the Payments Period to ascertain how it compares with the amount of credit suppliers are giving the business.
If more detailed analysis of the Collection Period is deemed necessary in order to adequately assess the liquidity of Receivables then a detailed Aged Analysis of Receivables should be examined. This will give a comprehensive view on the relative liquidity of the total Receivables of the business.
INVENTORY X NO. OF DAYS IN PERIOD
1.1.2 (iv) INVENTORY PERIOD ————————————- COST OF SALES
This is sometimes called the Inventory Turnover Ratio (when it would be calculated as Cost of Sales divided by Inventory) or Days Inventory or Days Stock and gives an estimate of the number of days stock in terms of cost of sales, being held in the business. This ratio effectively tells the number of days it takes to convert stock, in all its forms, into cash or receivables. It therefore can give a good indication of the liquidity of the Inventory element in Current Assets. Again it only gives an estimate and a more accurate calculation would require the use of average stock figures to avoid the distortions caused by seasonal factors. But it is useful and valid when prepared consistently and used to assess movements in the relative levels of stock over periods of time. It is sometimes calculated in relation to Sales rather than Cost of Sales which give a less accurate measure but a useable one if calculated consistently and viewed over periods of time.
(Like with the Collection Period it is important to use “No. of days” rather than 365)
It should first be compared with the budgeted level of inventory to assess the quality of inventory management and also to help form a view as to the “saleability” of the inventory. If items of stock are becoming “slow” then their liquidity deteriorates and the issue should be taken up with the relevant line management.
The Inventory Period should then be compared with the norm for the industry and any substantial deviations from the norm should be questioned with the line management involved. Stock levels usually relate closely to the production cycle in manufacturing businesses so it is important to know what is the normal production cycle for different businesses so that appropriate comparisons can be made.
It should then be compared with the Inventory Period for the previous accounting period to ascertain whether the situation has improved or disimproved. If there has been a change from one period to the next it is useful to take out an Inventory Period for each of the three component elements of Stock i.e. Raw Materials, Work-in-Progress and Finished Goods as follows;
R.M. X NO. OF DAYS IN PERIOD
RAW MATERIAL PERIOD = ————————————-
COST OF SALES
W.I.P. X NO. OF DAYS IN PERIOD
WORK-IN-PROGRESS PERIOD = ——————————————-
COST OF SALES
- Gs X NO. OF DAYS IN PERIOD
FINISHED GOODS PERIOD = ——————————————-
COST OF SALES
By examining each of these component Inventory Periods it will be possible to more closely identify where the changes in overall Inventory Period have occurred and will therefore facilitate a more incisive analysis and a more informed discussion with the relevant line management. These additional ratios will enhance the quality of the information on the relative liquidity of the inventory and thus contribute to the assessment of the overall liquidity of the business.
The historic Inventory Period can also be used as the benchmark against which to judge the validity of projections for future periods.
Finally it should be compared with the Payments Period to assess what level of support is being given by suppliers for the stock holding requirements of the business.
PAYABLES X NO. OF DAYS IN PERIOD
1.1.2(v) PAYMENTS PERIOD —————————————————
COST OF SALES
This gives an estimate of the number of days credit being taken from suppliers. Again it is an estimate not an accurate calculation and it does not take account of seasonal purchases and the element of Cost of Sales which is paid in cash e.g. wages, expenses etc.. It would also be more accurate if calculated on Purchases rather than Cost of Sales but if consistently calculated as above then viewed over periods of time it provides totally valid data for comparison purposes.
As with the Collection Period the Payments Period should firstly be compared with the period of credit being given by suppliers to ascertain whether the Creditors are being stretched and thus likely to put pressure on the businesses liquidity. In assessing the liquidity of Creditors this is a vital piece of information. If the Payments Period is well within the credit allowed period then the Creditors are not likely to be putting on any pressure.
The Payments Period should then be compared with the norm for the industry and for the geographic area in which the business is operating. If it is found to be less than the norm then the suppliers should be asked to extend the period and help to ease the pressure on liquidity.
It should be compared with the previous Payments Period to ascertain whether it has improved or disimproved over the period. As it is a figure which is almost totally within the control of the management of the business itself it should be possible to keep the Payments Period at the optimum level i.e. getting the best credit benefit from suppliers without incurring any of the costs (Loss of discounts, reputation etc.)
Finally it should be compared with the Collection Period and with the Inventory Period to ascertain the level of support being given by suppliers compared to the amount that has to be invested in Inventory and Customer credit by the business.
1.1.3 Leverage Ratios
These are sometimes referred to as Gearing or Debt Ratios and they describe the relationship between the contribution of the owners and the contribution of outsiders to the financing of the business. Leverage Ratios reflect the Capital Structure of the business and measure the level of Financial Risk inherent in the business.
TOTAL THIRD PARTY LIABILITIES
1.1.3 (i) OVERALL LEVERAGE —————————
This measures the total contribution by third parties to the financing of the business compared to the amount contributed by the owners. All Current and Term Liabilities are included in the Total Liabilities figure and the Shareholders’ Funds includes all Capital and Reserves. This ratio provides a measure of the overall level of risk being taken by the outsiders relative to the owners i.e. the Financial Risk
The appropriate level of leverage is determined by the trade off between business and financial risk. Business risk is the risk arising from all the normal trading activities of the business e.g. sales, production, HR etc.. Financial risk arises from the introduction of debt into the capital structure. The trade off is that if the business has high business risk then it can only take low financial risk whereas if the business risk is low then it can survive with a higher degree of financial risk. The key to acceptability will be the capacity of the business to generate sufficient cash to service the creditors and lenders making up the debt side of the Ratio. If the cash generating ability is not there then the level of the actual Leverage Ratio whether apparently good or bad is academic.
1.1.3 (ii) BANK LEVERAGE RATIO ——————
This is sometimes referred to as the Debt/Equity Ratio although all of these ratios could be called that. It relates the Bank Debt to the Shareholders’ Funds. It is a more selective leverage ratio and is very important in terms of the financial viability of the business because of the strong position which bankers usually put themselves in relative to other providers of funds.
In most cases bank debt is secured and loan agreements usually contain comprehensive powers for the bank to take action if this ratio gets out of line or some other financial deterioration in the position of the business occurs. It is vital therefore that the Bank Leverage Ratio is always kept at a level which is acceptable to the lending bankers.
LONG TERM DEBT
1.1.3.(iii)LONG TERM LEVERAGE RATIO —————————
This simply takes a more selective view of Leverage by focusing on the Long Term element of debt and comparing it with the owners contribution which is also a long term one. Long Term usually means 7 years. It is sometimes calculated in relation to Total Capital Employed rather than to Net Worth. It highlights the relative importance of Long Term Debt in the Capital Structure
This ratio can provide useful additional information for assessing the overall leverage position of the business. If, for example, the Overall Leverage Ratio was considered too high examination of the Long Term Leverage Ratio could indicate a significant proportion of the debt being long term and thus represent a larger element of deferred rather than current or imminent claims on the business. This could make the previously unacceptable level of Overall Leverage a lot more acceptable and indicate a lower level of financial risk. This ratio could be described as one which helps to define the “liquidity” of the businesses Leverage position.
1.1.3 (iv) PROFIT COVER FOR INTEREST —————————
This is also called the Times Interest Earned Ratio and is calculated by dividing Profit before Interest and Tax by the Interest Charges. It shows the number of times profit covers the interest.
It is an important ratio for monitoring the profitability and leverage trends and is particularly useful when viewed over periods of time in detecting adverse trends in both of these areas. If the Profit Cover for Interest (PCI) is low then the ability of the business to raise additional debt finance will be very restricted.
Although it is a useful ratio in detecting trends it does not necessarily indicate ability to actually pay Interest Charges. These, it must be remembered, have got to be paid in cash and having sufficient Profit Cover does not imply cash ability to pay. This point is often overlooked when the PCI is being used to assess leverage. It can therefore give a misleading view. It also does not take account of the capital payments associated with debt which will be much larger than the Interest and this can add to its misleading impression if its implications and deficiencies are not fully understood. This deficiency in the ratio can be partially overcome by calculating a DEBT SERVICE RATIO which will include the capital payments due in the period. It retains the deficiency that a cash obligation is being compared with a Profit figure which might not necessarily imply any availability of cash.
A better measure of ability to service debt would be to use ‘Free Cash Flow’ rather than profit and to include capital payments due with the interest charge. This would be calculated as follows:
OPERATING PROFIT + DEPRECIATION — INCREASES IN WORKING CAPITAL – CAPITAL EXPENDITURE
INTEREST + DEBT REPAYMENTS DUE IN PERIOD
All of these Leverage Ratios will help in assessing the extent of and the appropriateness or otherwise of the Financial Risk in the business.
1.2 Sensitivity Analysis
A significant part of all Financial Analysis particularly relating to projections involves Sensitivity Analysis. A simpler name for it would be “what if” analysis. It essentially involves assessing what are the implications for all the items in the financial statements of the business if any one or a combination of other items are changed. The full range of accounting ratios we have just looked at are used to do this type of analysis. They are also used in this way to forecast future financing needs in the form of projected balance sheets.
For example the Financial Manager might use sensitivity analysis to impress on the Sales Manager the importance of collecting from customers on time. If the credit period given to customers is, say, 60 days and the Collection Period is 90 days while annual sales are running at €1 million the actual Receivables will be €246,575. Applying simple Sensitivity Analysis the Financial Manager can point out what the Receivables would have been if they had been collected on time and as a result the amount of extra finance used to support them;
Current Receivables (90 days) = €246,575
Receivables if collected in 60 days = X 60 = €164,384
Extra Finance € 82,191
Similar exercises can be done in relation to Inventory and Payables.
Significantly more detailed Sensitivity Analysis would be needed to explore all the implications of the plans and strategies of the business. This will require testing whole ranges of options to identify what is the best mix of activities, volumes and assets and the best mix of creditors, debt and equity to finance them. The sensitivities of all of these factors can be tested by trying out varying Profitability, Liquidity and Leverage Ratios on the range of sales volumes considered likely. Doing this manually would be a laborious task but there is now a range of standard computer spreadsheet packages which can do endless variations literally at a stroke. Their use has greatly enhanced the scope and flexibility of Sensitivity Analyses while at the same time making them much more easily accessible and useable.
1.3 Stock Market Ratios
There are a number of key ratios which are used by investors to assess the relative merits of different Equity investments. When a business obtains Equity from the market these ratios become very important markers for assessing the performance of the business in addition to all the internal and other measures which would have been used prior to the public issue.
There are six such ratios:
- Earning Per Share (4) Dividend Yield
- Dividend Per Share (5) Dividend Cover
- Price/Earnings Ratio (6) Market to Book Ratio
1.3.1 EARNINGS PER SHARE (EPS)
PROFIT ATTRIBUTABLE TO SHAREHOLDERS
NUMBER OF SHARES IN ISSUE
This is the basic bottom line measure of a company’s performance from the shareholders’ point of view. It tells the amount of Profit attributable to each share.
Number of shares in issue implies that they rank for dividend. There may be other shares in issue which do not rank for dividend until sometime in the future. These should not be included in the basic calculation. An additional ratio called Fully Diluted EPS can be taken out to measure the full potential impact of the shares which don’t currently rank for dividend. This would measure the potential impact of share options granted to employees on the Earnings per Share
Compared over periods of time the EPS is the shareholders’ most important measure of the performance of the investment. Its particular importance for the shareholder derives from the fact that it adjusts profit for all changes in the volume of Equity in the business.
If, for example, a significant amount of new equity was raised from existing shareholders the Net Income would increase significantly but the shareholders’ return on their increased investment could be gone down. That’s why it is so important to look at earnings per share rather than just earnings in isolation The EPS automatically adjusts for such equity changes and thus gives fully comparable figures on which the shareholders can measure relative performance of their investments.
1.3.2 DIVIDEND PER SHARE DIVIDEND PAID TO SHAREHOLDERS
NUMBER OF SHARES IN ISSUE
This measures the amount of Dividend paid on each share.
Investors look for returns in two ways from equity investments. One is income and the other is capital gain. The Dividend per Share measures the income element of this return
The Dividend Per Share compared period to period is a vital measure of the increase in income return which the shareholder is getting.
While it is normally calculated on a net basis for purposes of comparison by investors with other investment opportunities it is more appropriate to look at the Gross figure. The Gross figure would include the relevant tax credit attaching to the dividend.
1.3.3 PRICE EARNINGS RATIO MARKET PRICE OF SHARE
EARNINGS PER SHARE
This is the first time we have introduced a market measure rather than internal measures which were used in all the previous ratios.
The P/E Ratio is the most important ratio used by the market to assess the relative rating of a share. It expresses the current share price as a multiple of the most recent EPS.
It identifies the number of years earnings needed to recover the current market price of the share and in that sense could be described as a potential “payback” measure.
It brings together the internal measure EPS with the external measure Share Value to give a market assessment of the performance of the business. It is the most important measure of the business and its prospects. The higher the P/E ratio the higher the market’s rating of the share.
While the P/E Ratio is calculated using the most recent historic earnings the multiple applied by the market is determined by the market’s view of the future rather than the historic performance of the business. Thus the P/E Ratio reflects the markets perception and expectations rather than past performance.
1.3.4 DIVIDEND YIELD DIVIDEND PER SHARE %
MARKET PRICE OF SHARE
This measures the percentage return in income that an investor would get by investing in the share at the current market price. The initial comparison should probably be with the income return available on bank deposit. It must be remembered, though, that bank deposits only give an income return while shares give income and offer the potential for capital gain or loss.
If the Dividend Yield is low it may indicate that the market expectations of growth in dividends and capital are high. If the Dividend Yield is high then it may indicate that investors expect low dividend and capital growth or that they require a higher rate of return to cover risk.
If there is a requirement for good income as well as capital growth then the Dividend Yield will be important to investors. If investors are more interested in capital growth then they will not attach much importance to the Dividend Yield. These factors need to be taken into account by the directors of the business when deciding on dividend policy.
1.3.5 DIVIDEND COVER EARNINGS PER SHARE
DIVIDEND PER SHARE
This is the number of times the dividend is covered by the earnings of the business. It can be calculated as the earnings of the business.
The Dividend Cover is a measure of the ‘ Quality’ of the dividend. If there is very high cover then it indicates good ‘quality’ dividend because even if there was a fall in income there would still be lots of profit to cover continued payment of the dividend. A high Dividend Cover may also indicate that the business has lots of good opportunities for investment within the business. If the Dividend Cover is low then it may indicate that there is not much scope for increasing or even maintaining the dividend should profits decline even marginally. Low Dividend Cover may also indicate that the business does not have good internal investment opportunities or that it may not be reinvesting sufficient to grow and develop the business.
It is also a measure of the Retention Policy of the business. If dividend cover is high then there is obviously a policy of retaining a substantial proportion of the profits. The market looks for good dividend cover to ensure stability of dividends which is a very important feature in the rating of a share.
Good Dividend Cover could be taken to be 2:1 but as in all such generalisations it really depends on the particular circumstances of each case and especially the risk profile of the industry sector and individual firm within it.
1.3.5 MARKET TO BOOK RATIO MARKET PRICE OF SHARE
BOOK VALUE PER SHARE
Book Value per Share is the Shareholders’ Funds divided by the number of shares in issue.
This is a very powerful measure as it compares the market valuation of the business with the internal Balance Sheet measure. In most cases it would be expected that the market value would greatly exceed the book value. The difference is accounted for by the markets assessment of the value of the key assets of the business that do not appear on the Balance Sheet. The main assets influencing this valuation are brands in all their formats, including customer relationships and intellectual capital including employee skills and knowledge and research and development.
Market to Book Ratio can also be calculated by multiplying the Price Earnings Ratio by the Return on Equity. This brings together the internal and the external market measures of the performance of the business.